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By Michael Gray

Table of Contents

• Happy New Year
• 4th quarter estimated tax due date is coming
• Time to review withholding exemptions for 2005
• Significant change in 2005 federal withholding for NQOs
• FASB says employee options must be expensed
• Questions and answers.
  • How can I become an expert in employee stock options?
  • Do I have to pay tax on replacement stock from my employer's acquisition?
  • Should my ISOs be treated like NQSOs after retirement?
  • Can I get employment tax withholding back from exercising NQSOs?
• Do you know about our other newsletter?
• Consult with a tax advisor.
• Subscribe to Michael Gray, CPA's Option Alert

Happy New Year

We wish you a happy New Year! It's time for a fresh start and to make resolutions to diversify your investment portfolio to protect your hard-earned gains. We'll do our best to continue to give you ideas to help you maximize the benefits of your employee stock options.

4th quarter estimated tax due date is coming

The due date for the final estimated tax payment for 2004 is January 18, 2004 (because of Martin Luther King's birthday holiday.) Remember that your estimated tax payments can be protected from penalties when they are based on the tax on last year's income tax returns (110% of last year's tax for individuals with adjusted gross income over $150,000 on last year's income tax return).

When you have a big tax because of exercising an employee stock option, you can often postpone paying the balance until April 15 of the next year.

If you need assistance with reviewing your 2004 estimated tax payments, call your tax advisor now.

Time to review withholding exemptions for 2005

When there is a major change in activity from year to year, it's important to review the exemptions that you claim on Form W-4. For California taxpayers, the California exemptions often don't correlate with the Federal amounts, especially for married taxpayers. Consider also submitting Form DE-4 for the California withholding elections.

Significant change in 2005 federal withholding for NQOs

One of the changes enacted in the American Jobs Creation Act of 2004 is to increase the withholding for some exercises of non- qualified stock options, effective for 2005. Supplemental wage payments (including bonuses and ordinary income from exercising a non-qualified stock option) exceeding $1 million are now subject to federal income tax withholding at the maximum federal income tax rate, or 35%.

The former withholding rate that still applies for supplemental wages up to $1 million was 25%. Many taxpayers found they owed additional income taxes when they prepared their income tax returns. Now they may find they are entitled to a refund because they have overpaid their federal income taxes.

FASB says employee options must be expensed

The Financial Accounting Standards Board has issued its expected rule requiring that companies expense the fair market value of employee stock options granted to employees.

The effective date when companies will be required to implement the new rule has been postponed until after June 30, 2005.

Meanwhile, the high-technology industry will continue to lobby Congress to further delay or outlaw the new rule.

During 2004, there was a dramatic drop in the number of employee stock options granted in anticipation of the new FASB rule. I believe employee stock options will continue to play a role for start-up companies, because they are a form of currency that can be created by the companies without a cash outlay.

Questions and Answers

Question

Here is a follow up to whether one can earn a designation as an expert in Employee Stock Options. The Certified Equity Professional Institute at Santa Clara University offers such a program. See http://cepi.scu.edu/about.htm.

Answer

Thanks for the feedback. It appears to me the program may be more oriented to plan administration than tax and financial planning. Individuals interested in getting certification should investigate for themselves. Another reader also pointed out that Kaye Thomas offers a certification program for advisors. Try http://www.fairmark.com for information.

Question

I work for private company X that was acquired by public company Y. I had ISOs for 20,000 shares of X, which were not exercised. When Y acquired X, all ISOs for X were exercised and were given to me part in cash, part in Y stock.

I understand that I have to pay tax for the cash portion that I received, but do I have to pay tax on the stock part, too?

Answer

It depends on the type of acquisition. If it was a purchase, and not a stock-for-stock reorganization, the stock is probably taxable. Your employee benefits department should be able to tell you the consequences of the transaction. Usually they issue a lot of paperwork for transactions like these.

Question

I retired in 2002 and was allowed to keep some ISOs expiring in 2008. I exercised them in 2004. The company is taking the position that the gain is ordinary income, subject to social security, Medicare, etc. and requesting payment of 25% of the gain as withholding. They will then send me a W-2 form. Do you agree with this position?

Answer

Yes. When an employee is allowed to keep ISOs after leaving an employer, they are converted to non-qualified stock options.

For income tax withholding, under Treasury regulations section 31.3401(a)-1(a)(5), "Remuneration for services, unless such remuneration is specifically excepted by the statute, constitutes wages even though at the time paid the relationship of employer and employee no longer exists between the person in whose employ the services were performed and the individual who performed them."

A similar rule applies under Treasury Regulations Sections 31.3121(a)-1(i) and 31.3306(b)-1(i) for FICA withholding and FUTA taxes.

There is an exception when an option is exercised after the year of death of a deceased employee. (Revenue Ruling 86-109.)

I do not work extensively in the area of payroll tax reporting. Employers should be seeking their own counsel in this area.

Question

1. I am retired over 5 years and on Social Security and recently exercised 3 options. My understanding is I will get a W-2 form from my previous employer and need to report it as income. Can I get the Social Security and Medicare deductions back when I do my taxes since I did not work in the past year and am on Social Security?
   
   
2. My understanding is that this income is considered as income from 5 years or more ago and does not go against my Social Security earnings limitation this year. Is that correct and how is that handled on the tax forms?

Answer

1. See the previous answer. You appear to be subject to these employment taxes and won't receive a refund for them.
   
   
2. There is no special disclosure on your income tax return, but the income from the exercise of the non-qualified option is separately disclosed on Form W-2. Hopefully that will help the Social Security Administration determine these aren't "disqualified" earnings. I believe you are right that your Social Security benefits should not be reduced because of ordinary income received from the exercise of a non-qualified option after retirement, but I don't have extensive resources about Social Security, so I can't give you an authoritative answer. Try calling the Social Security Administration at 800- 772-1213 or visit their website at http://www.ssa.gov. Once you reach full retirement age, your benefits aren't reduced for "excess earnings."

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Michael Gray regrets he can no longer answer emails personally. He will answer selected questions in this newsletter.

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Do you know about our other newsletter?

For general tax developments, tax planning ideas, business development ideas and book reviews, subscribe to Michael Gray, CPA's Tax & Business Insight at http://www.taxtrimmers.com.

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IRS Circular 230 Disclosure:

As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.

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Consult with a tax advisor

For our readers who aren’t tax advisors, this newsletter is intended to alert you about tax issues that could affect you. It is not a substitute for advice from a professional tax advisor. You will find that getting advice from a qualified advisor is a worthwhile investment.

Tax advisors should view the newsletter as an alert to become aware of issues relating to employee stock options for further research and study.

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(Michael Gray is the co-author of Employee Stock Options – A Strategic Planning Guide for the 21st Century Optionaire. You can order the book at http://www.amazon.com or http://www.barnesandnoble.com/ or buy it at Stacey’s Books.)

P.S.

To receive the next issue of Michael Gray, CPA's Option Alert with more employee stock option tax developments and answers to questions from our readers automatically via email, subscribe by filling out the form below.